With U.S. stock markets continuing to trade near record highs, many investors are wondering if we might see a stock market crash this year. You see, we're in an almost nine-year bull market that is full of over-priced stocks.
The S&P 500 ended 2016 up nearly 10% after a sluggish start. The Dow Jones Industrial Average (DJIA) posted gains of 13.5% in 2016 and is now closing in on the psychologically significant 20,000 level. The Dow is down to 19,932.17 after coming within a half a point of the 20k level on Friday.
With stocks near historically high prices, we're seeing some of the same red flags we've seen from stock market crashes before. That's why we've researched the previous signals of a stock market crash...
Learning from Past Stock Market Crashes
No one can predict the exact movement of the markets. However, understanding the bumps of the past and the signals the market gives can help us make educated guesses about what is coming next.
When most of us think of a stock market crash, we picture the resulting recession or even the Great Depression. The infamous stock market crash of 1929 occurred in October when the bubble boom of the Roaring Twenties popped.
The Roaring Twenties was a time when prosperity reigned, with commercialized autos, aircraft, and new technology like the radio. There was mass speculation in the stock market, often with borrowed money.
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By October 1929, the market had peaked, and then it crashed in spectacular fashion. The Dow dropped 12% on Black Tuesday and was down 90% by the time it bottomed out in 1932. It took 25 years for stock prices to regain pre-crash levels.
The stock market crash of 2008 is our most recent experience with a major crash. Speculation was involved in this market tumble, but there was risk taking of a different sort involved with this crash.
The American dream of home ownership was becoming a reality for many Americans in the years leading up to the crash. Between 1996 and 2006, home prices in the U.S. had nearly doubled.
There was a real estate bubble nationwide that was also spurred by a rise in subprime mortgages. Repealing regulations and new regulations in 2000 that made lending easier caused many banks to lend money to unqualified borrowers.
This bubble burst when home values dropped, borrowers were upside down on loans, and default rates skyrocketed. The result was a 7% point drop in the Dow on Sept. 29, 2008, and a 54% stock market plunge in under 18 months. The resulting recession saw unemployment rates as high as 10%.
With interest rates rising and an overvalued market, being concerned that 2017 will be the year that history repeats itself with another stock market crash isn't far-fetched...
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Signs a Stock Market Crash in 2017 Could Happen
While we didn't see a stock market crash in 2016, the prognosis is not all positive going into 2017. The Fed voted to raise interest rates by 0.25% on Dec. 14. While this was probably the right thing to do for the economy, these rate hikes are often followed by market drops.
The last time the Fed raised rates was in Dec. 2015, and the markets lost 5% of their value in January 2016, with 93% of investors ending the month in the red.
The market doesn't always go down after a rate hike. Over the last 35 years the market has averaged a small gain of 2.6% in the 250 days after a rate increase.
A case can be made for a sluggish economy in 2017 since the Fed has also announced that it intends to raise interest rates three more times this year. If they make good on their promise, the chances of a stock market crash go up dramatically.
When we looked at our stock market crash history, speculation was brought up repeatedly. There is little doubt that our markets are overvalued going into 2017. In fact, according to the Case-Shiller cyclically adjusted price-earnings ratio, the S&P 500 is overvalued by 73%. A large part of this overvaluation ties back to interest rates.
After the last recession, the Fed dropped interest rates in the hopes of stimulating the economy and encouraging corporate growth. Corporations did take advantage of the low rates to borrow mass amounts of cash, but they didn't use those funds for the growth and expansion intended.
Instead, they bought back shares of their own stock, boosting corporate share prices and giving us an overvalued market. From 2008 to now, corporations have taken on $1.91 trillion in debt and repurchased $2.2 trillion of their own shares.
To put the stock buyback programs into perspective, the economy as a whole grew 6.8% from 2009 through 2012. The S&P 500 posted gains of more than 60% for the same time period.
Unfortunately, the underlying fundamentals of the economy and the companies don't support many of these inflated stock prices, which has produced a stock market bubble. This sets us up for a potential crash in 2017.
And because there is a possibility of a stock market crash, investors need to have a protection plan. Here's how we recommend protecting your investments in the event of a serious stock market pull-back...
Surviving a Stock Market Crash This Year
Even if there is a stock market crash this year, there are ways to both protect yourself financially and possibly even profit in 2017.
Money Morning investment experts recommend holding anywhere from 10% to 20% of your investment portfolio in gold. You can certainly buy physical gold, but this is a burden and can come with additional shipping and storage costs.
Instead, consider investing in gold ETFs. A Money Morning favorite is the SPDR Gold Trust (NYSE Arca: GLD) ETF. This is a gold-backed ETF whose performance will mirror that of gold.
Money Morning Chief Investment Strategist Keith Fitz-Gerald recommends that investors protect themselves from a potential stock market crash by putting their money into "Unstoppable Trends." These are companies in industries where demand will continue to exist, regardless of market conditions. The industries that Fitz-Gerald includes are health, demographics, war, energy, scarcity, and technology.
Several stocks in these areas that will protect your money include Raytheon Co. (NYSE: RTN), which is one of the world's largest defense companies; Microsoft Corp. (Nasdaq: MSFT), a top global tech company; and Becton Dickinson and Co. (NYSE: BDX), a medical supplies company.
Finally, if the market falls, you can position yourself to reap some hefty gains with a reverse ETF. This is a fund that will move inversely with an index.
This is not a buy-and-hold, long-term strategy since the markets rebound after a crash. The best time to pick this one up is when you believe that a stock market crash is a certainty. The ProShares Short S&P 500 (NYSE Arca: SH), for example, will rise 1% as the S&P drops 1%. But these are not long-term investments. If the market is not falling, these ETFs will not be profitable.
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